What is the Optimum Tax Rate?

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With all the dither over tax rebates and the comments over making Bush's tax cuts permanent in the SOTU address, I got to thinking over what should the overall tax rate be. This is not to say who should pay, rich versus poor, etc, only what is the optimum rate and how would you tell that you got the correct number?

While some folks would like zero taxes, this is obviously bad for the economy. No police or firefighting, no roads and other infrastructure, no military results in little economic activity. Likewise 100% taxation is communism and provides no personal incentive to excel, hence lower economic activity. The optimum rate is somewhere in between and may shift over time.

I can't say what the correct rate is, but I can say I think taxes are currently too low. I hate to pay taxes as much as the next guy and I have been a big beneficiary of the tax cuts from the last few years, but I reach my conclusion looking at two points.

First, I think we are underspending on infrastructure. Our bridges and roads are aging, we aren't investing in next generation transportation like high speed rail, and we are leaving things like telecommunication infrastructure and electrical generation developement to the private sector. Much of our infrasturcture spending is done by state and local governments and there does not seem to be a national priority on developing and maintaining our competitive position through proper infrastructure. Here's an interesting read. ASCE Infrastructure Report Card

Second, I look at money available for investment. Taxes pull money out of the system making it harder for businesses to borrow capital, so if taxes are too high, I would expect businesses to face challenges in this area. This is where Reagan was when he pushed through tax cuts. But looking at Wall Street today, it looks like we have the exact opposite problem. There is a lot of free cash out there, businesses are going private, venture firms are flush with cash. Based on this alone, I don't think a tax cut will further stimulate the economy. Nor is the economy necessarily more stimulated by personal spending than it is by government spending. If government spending is local and consumer spending is international, government spending is more beneficial than consumer spending. Of course if government spending is international, it doesn't help at all.

From this rather simple analysis, I conclude that we are currently lower than the optimum taxation rate. Further tax cuts would actually hurt the economy. The reason that we've avoided these impacts so far is that the federal government has been borrowing to prop up the economy, but that can't last forever either. Thoughts?

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History has shown that a tax rate at 17-21% of GDP doesn't really affect GDP growth one way or the other. We are currently at the low end of that tax rate.

During that same time frame government outlays have been in the 18-24% range of GDP. 19-20% seems to be the optimum tax and expenditure rates to balance the two.

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Ideally it would be the same for everyone. Graduated taxes suck (the incentive out).

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cjhsa wrote:

Ideally it would be the same for everyone.

How we spread out the taxes is another sticky issue. My concern is that based on what I see in the markets and elsewhere, we are applying a strategy that was appropriate in the early 80's to a completely different situation and may be damaging the long term economy instead of benefiting it by issuing tax cuts or tax rebates. I just read another article suggesting that we stimulate the economy by implementing another generous WWII like GI Bill. To me, that is a "soft" infrastructure investment right in line with what I think a stimulus package should look like. While I would love a check from the government as much as anyone else, I don't think it is good stimulus. My wife suggested we might use that check to get that big screen TV, but my thought was that that would be doing a good job stimulating the Korean economy instead of ours.

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I plan to save mine for unexpected car repairs. The roads are in terrible shape here. I would also like to see more infrastructure spending.

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Thoughtful posts, engineer, I agree. I especially agree with the willingness to pay more taxes. I sure as heck don't WANT to, but I see the need for it.

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sozobe wrote:

Thoughtful posts, engineer, I agree. I especially agree with the willingness to pay more taxes. I sure as heck don't WANT to, but I see the need for it.

And as Parados mentioned, some of this data is out there already. I guess it must be considered political suicide to say that the economy benefits from higher taxes, but common sense says at some point, that must be true. And as cjhsa mentioned, who pays those taxes is just as thorny as how much we should pay. I just think we are on the wrong track and both Democrats and Republicans are pushing us down that track as hard as they can.

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Another thing I thought about was spending 1/2 of it on a new gun and a dog to go with it. Wouldn't that be a kick in the pants if the economic surge from the rebate was largely felt in the firearms industry, just as America appears ready to elect a gun grabber (all of the leading candidates are).

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cjhsa wrote:

Another thing I thought about was spending 1/2 of it on a new gun and a dog to go with it. Wouldn't that be a kick in the pants if the economic surge from the rebate was largely felt in the firearms industry, just as America appears ready to elect a gun grabber (all of the leading candidates are).

At least that would tend to spur the economy. Are your firearms of US manufacture? (I'll assume your dog is.)

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engineer wrote:

Are your firearms of US manufacture? (I'll assume your dog is.)

Point taken. Guess I have to cross that Glock 20 off my wish list.

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cj always steers the discussion to guns. Hey, this about tax rates!

The graduated rates should be steeper. The the income and wealth of the very wealthy are soaring, while the middle class is economically sinking. We are in a plutocracy, which can bring down this country. Paris Hilton and Teresa Heinz could well pay more tax without a sweat.

Any tax cuts should be focused. For instance, small business is the source of new jobs, and tax help here could be appropriate.

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Advocate wrote:

cj always steers the discussion to guns.

In this case I was quite serious about it though. That is what I am considering spending a portion of my rebate on.

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without war or disaster, the rate that balances outgoing funds. is that the reasonable place to begin? because it has to be predicated on what is deemed necessary to fund the actions of the government. thrash out what is contained under the penumbra of "deemed necessary," and that is the amount of money in taxes you need. divide it up, that's the tax.

i really do not know how to do it any other way and be consistant with common sense.

but i've always delighted in the cruel and cunning logic of morton's fork.

http://en.wikipedia.org/wiki/Morton's_Fork

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Engineer, I think you're well on the way to developing the Laufer curve. Sadly, Laufer didn't have an answer for your question, either.

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6% on each and all transactions. Split evenly betwixt county state and fed. Should cover defense, state militia, public works, international interests, criminal law, common law, business law, research grants etc. If it doesn't we're doing something wrong to begin with, so why fuel the fire?

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kuvasz wrote:

without war or disaster, the rate that balances outgoing funds. is that the reasonable place to begin? because it has to be predicated on what is deemed necessary to fund the actions of the government. thrash out what is contained under the penumbra of "deemed necessary," and that is the amount of money in taxes you need. divide it up, that's the tax.

i really do not know how to do it any other way and be consistant with common sense.

But I don't know that that is the optimum value to stimulate the economy. Maybe it should be the rate that balances what the government should be spending. Unfortunately, that number is hard to determine. More infrastructure is generally good, but pork is bad. A strong military is a proven positive for economic growth, but a hyper military engaging in unprovoked foreign wars is a drain on the economy. Some social safety net is good. (Basic preventative healthcare, childhood nutrition, etc all have positive overall impacts on the economy.) Too much and you provide incentives for the able bodied not to work.

What indicators would you look at to see if you have the right number? That is my dilemma. I've suggested the availability of capital and the state of infrastructure as a couple of examples. Infrastructure especially is where we are underspending compared to countries in Asia and to a lesser extent Europe. Just at a high level, it looks like the optimum tax rate is too low for maximum economic growth. How can you sell that on a Federal level without getting hammered?

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hanno wrote:

6% on each and all transactions. Split evenly betwixt county state and fed. Should cover defense, state militia, public works, international interests, criminal law, common law, business law, research grants etc. If it doesn't we're doing something wrong to begin with, so why fuel the fire?

Michigan has a 6% sales tax and the state is broke. There are few transactions that aren't subjected to the tax. Are you suggesting that food be taxed? That is a tough row to hoe.

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engineer wrote:

kuvasz wrote:
without war or disaster, the rate that balances outgoing funds. is that the reasonable place to begin? because it has to be predicated on what is deemed necessary to fund the actions of the government. thrash out what is contained under the penumbra of "deemed necessary," and that is the amount of money in taxes you need. divide it up, that's the tax.

i really do not know how to do it any other way and be consistant with common sense.

But I don't know that that is the optimum value to stimulate the economy. Maybe it should be the rate that balances what the government should be spending. Unfortunately, that number is hard to determine. More infrastructure is generally good, but pork is bad. A strong military is a proven positive for economic growth, but a hyper military engaging in unprovoked foreign wars is a drain on the economy. Some social safety net is good. (Basic preventative healthcare, childhood nutrition, etc all have positive overall impacts on the economy.) Too much and you provide incentives for the able bodied not to work.

What indicators would you look at to see if you have the right number? That is my dilemma. I've suggested the availability of capital and the state of infrastructure as a couple of examples. Infrastructure especially is where we are underspending compared to countries in Asia and to a lesser extent Europe. Just at a high level, it looks like the optimum tax rate is too low for maximum economic growth. How can you sell that on a Federal level without getting hammered?

the number to look at is the one where the tax rate passes into law. you are attempting to set an objective rate that can be only derived subjectively in the halls of government.

if the tax code were a box, into which you need to place a goverment's spending you are unable to determine the dimensions of it until you know what you want to use it for.

calling for a specific tax rate without determining what the taxes need to pay for is looking at the situation incorrectly, you first have to decide what is necessary to do with the taxes.

it is not a dilemma, it is politics.

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kuvasz wrote:

the number to look at is the one where the tax rate passes into law. you are attempting to set an objective rate that can be only derived subjectively in the halls of government.

if the tax code were a box, into which you need to place a goverment's spending you are unable to determine the dimensions of it until you know what you want to use it for.

calling for a specific tax rate without determining what the taxes need to pay for is looking at the situation incorrectly, you first have to decide what is necessary to do with the taxes.

it is not a dilemma, it is politics.

You could argue that there is plenty of money available is we stop spending on pork projects and to some extent I think that is true, but pork as an overall fraction of government spending is not very large. You could also argue that our priorities are wrong in terms of where we spend our money. I agree that's straight up politics.

But politics today is calling for a reduction in taxes (in the form of tax rebates) to spur the economy. I think a reduction in taxes will in the short run won't do much more than transfer private debt to public debt and in the long term will hurt economic growth based on where I think we are on the growth versus taxes curve.

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What is the Optimum Tax Rate?

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